Michael Lewis' book, Flash Boys, exposes one of Wall Street's newest scams, high-frequency trading, or HFT for short. HFT is at the heart of a greatly altered system for buying and selling common stocks that has completely transformed the way markets worked five or ten years ago.
In those good old days there were real people standing on the floors of stock exchanges "making markets" in different stocks. This meant that if there was an order to sell IBM and no orders to buy it, the market maker or "specialist" would use his firm's funds to purchase the shares being offered. In the opposite case of an order to buy with no matching order to sell, the specialist would sell shares out of his inventory to fill the buyers order. Specialists made a profit by buying at lower prices when sell orders exceeded buy orders and selling at higher prices when an excess of buy orders pushed prices up. This was called "supplying liquidity," which was literally the case, in one sense of the word, when funds were provided for a purchase, and in another sense as he enabled trading to continue to flow smoothly like water by connecting buy and sell orders which were separated in time. It was a difficult and risky job that required skill, moral integrity and capital.
As trading volumes increased and institutional investors became much larger, the capital requirements to be a specialist increased. In addition, very large investors like the mutual fund manager, Fidelity, had difficulty keeping their trades from becoming public knowledge because the size of those trades was itself an identifying flag. Indeed one common explanation of the stock market crash in October, 1987, when the US market lost nearly one fourth of its total value in a single day, was that declines earlier in the day in overseas markets had been caused by Fidelity placing large sell orders. Since nearly everyone, including the undersigned, believed that stocks were overpriced (incorrectly in retrospect) the idea that one of the largest investors was heading for the exit was thought to have triggered a stampede among other investors.
One response to this need for anonymity was the creation of electronic markets apart from the stock exchanges and open only to large investors. The idea was to automatically pair large orders while preserving the anonymity of both parties to the trade and keeping the existence of each order invisible until after it had been successfully executed. Where stock markets were meant to be transparent and open, these new markets were meant to be opaque, secretive and open only to a small group of members. It is thus natural that they have come to be known as "dark pools." Most dark pools are now owned by major investment banks like Goldman Sachs or Barclays as well as some of the stock exchange companies themselves.
We will get back to high frequency trading in a moment; but first we note one more major transformation of stock trading. It began many decades ago but has accelerated in recent years, in part because of the possibly unintended consequences of new Securities and Exchange Commission rules issued in 2005 for the purpose of creating instantaneous access to trading information about stocks that are traded in more than one market. The first unanticipated consequence is a rapid shift of trading from the New York Stock Exchange and other traditional exchanges to electronic trading "platforms" that consist only of a computer. The second unexpected result has been the rapid multiplication of these electronic "exchanges" that now number nearly 50.
Which brings us full circle to the third unanticipated consequence (or perhaps cause?) of all these changes: high frequency trading, the main subject of Michael Lewis' book. HFT accounts now for about two-thirds of the total daily volume of trading in US stocks. What they do is nearly the opposite of what a stock exchange specialist used to do and still does when trades come to the old fashioned exchanges. They invest in fast computers with sophisticated software placed as close to major exchange computers as possible and connected to other trading venues by the shortest, straightest and thereby fastest fiber optic cable routes. And what is the point of this? To learn before anybody else that somebody wants to trade a particular stock so that the HFT can trade it before the investor and then trade it again with the investor at a less advantageous price.
The mechanics of how this is done are well explained in the book. Different approaches are used in different trading locations. What they all have in common is that the HFT firms pay for privileged access to buy and sell orders, sometimes before they are even placed at any exchange or trading platform. Directly or indirectly they pay many brokers for information about their customers trades; they pay the investment banks for access to their dark pools, unbeknownst to the large investors who go there for confidentiality; they pay stock exchanges and electronic platforms for instantaneous access to information about new orders. Then they buy or sell the very stock that an investor had meant to buy or sell milliseconds (thousandths of a second) ahead of the investor's electronic order and retrade it with the original investor at a less advantageous price than they otherwise would have paid or received.
So, while the HFT people claim they are providing the markets with liquidity, just as specialists did in the days of pre-electronic trading and most of the Wall Street establishment has embraced this story, it seems obvious that HFT is a scam and a public disservice. What is the difference between HFT and Whitey Bulger, or any gangster collecting protection money from stores and bars so that they can go about their normal business without being attacked? Lewis estimates this protection money is somewhere between twenty and 40 billion dollars a year. And, as he points out, this is money that pension plans, individual retirement accounts, college savings plans and charitable endowments are losing every year.
Flash Boys has had a prompt and strong impact in a way that few books have ever achieved -- think Michael Harrington's The Other America, Rachel Carson's Silent Spring, Ralph Nader's Unsafe at Any Speed and Jonathan Schell's The Fate of the Earth. The Securities and Exchange Commission has launched an investigation along with several committees in Congress, while the Attorney General of NY State has brought charges against Barclays for selling HFT firms access to its dark pool. And suddenly all the newspapers are reporting what anyone could have read in Flash Boys as if it were hot off the wire.
The shocking thing is that it took Lewis' book to enable everyone to notice the elephant in the room which had been busy breaking the pottery for quite a few years. HFT is the reason that volume levels have more than doubled in recent years; the reason for the Flash Crash in 2010 when prices plunged for a ten minute period in which $100 stocks changed hands for a few dollars or a few pennies and numerous similar electronic "glitches" in subsequent years. But the Securities and Exchange Commission, the financial press and Wall Street firms chose to close their eyes, take their payoffs in many cases, and pretend that nothing was amiss and HFT was a good thing.
The real value of the book is that its detailed description of this particular scam provides a universal blueprint of the way all such scams work on Wall Street, throughout the financial industry, and to some considerable extent in other industries that extract exorbitant tolls from our economy through combinations of political influence and economic power, such as healthcare and weapons.
It is much to be hoped that this particular criminal enterprise will soon be extinguished, to be followed inevitably by yet another larcenous scheme pulled out of a hat by the wizards of Wall Street.